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The U.S. Court of Appeals for the Fourth Circuit recently affirmed the dismissal of a borrower’s lawsuit against a bank, holding that the district court correctly found that sale orders entered in a prior bankruptcy case were res judicata and precluded the borrower’s new claims.

A Virginia-based limited partnership owned real property in several states, and entered into a line of credit and loan secured by deeds of trust or mortgages. The borrower defaulted and filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.

The bank filed a proof of claim, to which the debtor objected and filed an adversary complaint, which was later amended. The amended complaint alleged that the bank misrepresented that it would forego suing on the credit line, which caused the debtor to default and file bankruptcy.

The U.S. Trustee moved to convert the case to Chapter 7 or to dismiss based on the debtor’s failure to file monthly financial reports. The bank joined the motion, arguing that the debtor had also improperly used the bank’s cash collateral to pay “distributions” to its principals.

The bankruptcy judge appointed a Chapter 11 trustee instead of converting the case to a Chapter 7 proceeding or dismissing the case.

The Chapter 11 trustee obtained the bankruptcy court’s approval to sell two of the debtor’s properties to satisfy the debt owed to the bank. He also consented to the dismissal of the debtor’s adversary complaint without prejudice.

More than one year later, the debtor sued in Virginia state court and the bank removed the case to federal court. The complaint repeated the claims raised in the prior adversary complaint and alleged the bank was liable because the interest rate swap transaction was a “sham” because the LIBOR rate was illegally manipulated or “rigged.”

The bank moved to dismiss and the district court granted the motion, reasoning that the bankruptcy court’s two sale orders were preclusive on the basis of res judicata. The debtor appealed.

On appeal, the Fourth Circuit explained that “[u]nder the doctrine of res judicata, or claim preclusion, ‘[a] final judgment on the merits of an action precludes the parties or their privies from relitigating issues that were or could have been raised in that action.’ … Three elements must be satisfied for res judicata to apply. ‘[T]here must be: (1) a final judgment on the merits in a prior suit; (2) an identity of the cause of action in both the earlier and the later suit; and (3) an identity of the parties or their privies in the two suits.’”

In addition, the Court explained, there are two practical considerations: first “whether the party or its privy knew or should have known of its claims at the time of the first action”; and second, “whether the court that ruled in the first suit was an effective forum to litigate the relevant claims.”

As to the first res judicata prong — whether the sale orders were final orders — the Fourth Circuit relied on decisions from the Fifth, Sixth and Seventh Circuits to find that the bankruptcy sale orders were orders or judgments on the merits.

The Court rejected the debtor’s argument that the cases relied upon by the district court were distinguishable because the debtors never objected to the sale orders or the creditor’s claim in the bankruptcy court, unlike [the debtor in the case at bar] which objected to [the bank’s] proof of claim” because, as the Fifth Circuit held in the Baudoin case, “sale orders ‘are final judgments on the merits for res judicata purposes, even though the order neither closes the bankruptcy case nor disposes of any claim.’… It is irrelevant whether an objection was made.”

The Fourth Circuit also rejected the debtor’s argument that its claims were unrelated to the sale proceedings, while in the Seventh Circuit’s Met-L-Wood case, the trustee alleged fraud surrounding the sale, reasoning that the distinction was “not a meaningful one.”

“To sell bankruptcy estate assets outside the ordinary course of business, the trustee of the estate or the debtor-in-possession must initiate the sale proceeding. … Here, the trustee moved to sell property in satisfaction of specifically identified obligations arising out of [the debtor’s] transactions with [the bank]. The bankruptcy court approved these sales, finding them to be ‘in the best interests of the Estate.’ … It would make little sense after the sales were made, the debt settled, and the bankruptcy proceeding closed, to then allow [the debtor] to challenge in a new judicial proceeding the propriety of the transactions giving rise to its now-extinguished debt. To allow such a challenge would achieve little more than upending the purpose of res judicata: promoting finality and judicial economy.”

The Court also found that “the preclusive effect of the bankruptcy court’s sale orders is consistent with the ‘fundamental purpose’ of Chapter 11 bankruptcy: ‘rehabilitation of the debtor.’ … To fulfill this objective, ‘[c]entralizaiton of disputes concerning a debtor’s legal obligations is especially critical’ because it allows ‘reorganization [to] proceed efficiently, unimpeded by uncoordinated proceedings in other arenas.’”

Rejecting as unpersuasive the debtor’s arguments that it should “break ranks with our sister circuits and hold that the sale orders fail to satisfy the first prong of res judicata,” the Fourth Circuit found: (a) the fact that the adversary proceeding was dismissed without prejudice was irrelevant because “the sale orders are what preclude the claims now before the court”; (b) res judicata bars personal lender liability claims even though the bankruptcy sale order is an in rem proceeding; (c) because the bankruptcy trustee “could have litigated the extent of [the debtor’s] obligations to [the bank] rather than move to sell estate property in satisfaction of those obligations, and … [the debtor’s] present claims are transactionally related to the facts underlying the sale orders … [t]his gives rise to the preclusion of [the debtor’s] present claims.”

Turning to the second prong of res judicata—“an identity of claims between the first and second suit”—the Court explained that it follows the “transactional approach” which means “that ‘res judicata will bar a newly articulated claim’ if it is based on the same underlying transaction [involved in the first suit] and could have been brought in the earlier action.’”

The Fourth Circuit found the second prong was satisfied because the sale orders arose out of the same facts as the debtor’s claims in the case at bar, i.e., the loan agreements between the debtor and the bank; the sale orders provided for the satisfaction of the debtor’s obligations arising from the loan agreements; and, in the case at bar, the debtor was challenging the propriety of the sale transactions.

The Court also found that the third res judicata prong—identity of the parties or their privies—was satisfied because the trustee is in privity with the debtor in his capacity as representative of the bankruptcy estate.

Finally, the Fourth Circuit concluded that the two “additional considerations”—“whether the party or its privity knew or should have known of its claims at the time of the first action and whether the court that ruled in the first suit was an effective forum to litigate the relevant claims”—were met because the debtor offered no argument that the trustee could not effectively litigate in the bankruptcy court.

Compare jurisdictions: Arbitration

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